5 Reasons Why Good Energy Projects Don’t Get Financed

Most energy projects never get beyond the development process. There are many reasons for this, but failure to obtain financing has derailed an increasing number of projects over the past few years. The most common reason is the fundamental economics of the project do not provide confidence in an adequate return being paid to investors. There is effectively no hope for obtaining financing for any energy project if the project developer cannot demonstrate sound economic fundamentals to a potential investor.

Mike DellaGala and Jonathan McClelland’s recent article in AOL energy does a great job laying out the building blocks for financing a solar project. While some of the specifics of a solar development don’t apply universally (for example, solar trading credits and the solar resource are uniquely relevant to solar), the broad principles cover the key aspects of the basic economic story for an energy project.

More challenging to understand than failed economic fundamentals is why some projects do not get funded even where a developer can demonstrate solid financial fundamentals and the potential for returns that appear to reflect the investment risk. Over the past three years there has been consistent talk of how much “money is sitting on the sidelines” looking for good energy projects. Energy investors are commonly heard to say “if the project is really that good, it will get financed,” yet some projects that appear to be good, or even to be very good, don’t ever find financing.

The basic economic equation of whether a project gets funded turns on the level of certainty that an investor will get paid back its investment plus a return for the use of its money. How investors measure risk, formally and unconsciously, varies and many of the explanations for why projects fail to get funded grow out of unrealized risk intolerance. There are obvious risks, like technology or an electricity buyer’s credit worthiness. And there are risks that manifest in less obvious ways.

1) Wrong Team

Presenting the right team is vital to attracting investors. The person making, or facilitating, the investment in a project has to believe in the people that make up the team (though established brands with solid track records can sometimes substitute). In a conversation last week with a successful energy investor, he told me “it could be the best project I’ve ever seen, but if it’s the wrong people I would never invest.”

How the wrong team manifests itself can take a number of different forms. It could be that a key piece is missing – for example, the lack of natural gas trading experience for a team trying to build a series of congregation plants where the projects will carry gas price risk. It could be that a team seems too willing to take on excess risk – that eagerness raises immediate red flags, especially in the conservative investment attitude prevalent following the financial collapse of 2008 and subsequent financial failures in Europe. It could be the other side of risk — that a team appears too conservative — while not as frightening as rapid and catastrophic loss of invested capital by excessive risk, the likelihood of slow steady losses without progress simply won’t draw investments either.

It could be something much more fundamental (and more difficult to manage) – the investor does not like one or more members of the team. Some people just don’t like each other, and in the end, regardless of how analytical anyone tries to be, investment decisions are decisions made by people. Personal dislike can be overcome, but it is worth taking a hard look at the potential for developing an actual connection with an investor. Getting a funding commitment without a personal connection (or worse, a bad connection) will be far more difficult than where a good relationship exists. Smart people with good ideas get passed over every day for the simple reason that an investor does not like them.

2) Projected Economics are Discounted as Overly-Optimistic

Project developers are optimists, so it is not uncommon for an investor to look on the financial assumptions of a project as unduly optimistic. Some investors test project economics by looking at every input assumption in the financial model that is not contractually fixed and then increasing the cost inputs or reducing the revenue expectations. From another recent investor conversation: “…the assumptions are speculative, someone pitching me believes in their story, and so necessarily will make optimistic assumptions, and I correct for those.” It is important to carefully stress-test pro forma inputs and illustrate that the assumptions are reasonable and well defined, and that project economics work against less optimistic scenarios.

This potential adjustment should not be viewed as a reason to make input assumptions more optimistic in order to build a negotiating position on the economics of a project, because unrealistic assumptions lead directly to reason #5 below for the project not getting funded.

3) Market or Policy Uncertainties

Much of the market uncertainties in a typical energy project can be partially managed by a long-term fixed price off-take contract (such as a power purchase agreement), which shields an investor from most price volatility risk. For example, a solar developer can assume payment, at a known price, for electricity it generates if that electricity is sold under a solid long-term power purchase agreement. The project will receive the expected revenue regardless of the price movement of electricity, which allows for revenue certainty and protection for the project in the event prices drop below levels used to calculate project returns. Where a long term contract is not available, an alternative strategy is to add a hedge (which is an instrument that acts as an offset or guarantee against the price going up or down).

However, hedging is generally difficult to do beyond a few years, and since project performance is often measured over 10 to 20 years it often only manages price risk during the early operation of a project.

When building a typical energy project, at least in the current market, a long-term contract for electricity is assumed. Without that long-term contract, securing financing for a power project would be virtually impossible. Long-term contracts for natural gas, crude derivatives, and biomass feedstock are generally not available. Projects subject to markets for these commodities, therefore generally have to have higher margins to provide comfort to investors.

Policy uncertainty can prove even more challenging than market uncertainty. Policy uncertainty occurs in various ways, from the potential for a new regulation increasing emission controls on a coal-fired power plant to the potential expiration of a tax credit for wind power. Hedge mechanisms (and certainly long-term contracts) don’t really exist for policy uncertainty. Additionally, the outcome of policy uncertainty is typically binary, so it represents an all or nothing risk with respect to particular pieces of project economics. While there may be rare instances where a development team could demonstrate an ability to affect the policy making process, as a general matter this is the kind of risk that is outside of a developer’s control.

4) The Project Doesn’t Match an Investor’s Areas of Interest or Mandate

The development team needs to know its audience and needs to know where to focus time and energy. Seeking project funding from a venture capital firm for a biomass gasification unit, even one using new technology, likely is not the best use of time. Similarly, it will likely be challenging to get a regional bank in Florida to provide financing for a Pennsylvania shale development. Not that it can’t happen that an investor will look outside of an area of focus or comfort, and sometimes diversification is exactly what an investor seeks, but matching the ask to an investor’s interest is vital if there is a real hope of getting funding. While a few investors will look at any good deal, the investor’s experience, interest, portfolio fit, stated goals or strategy, and liquid investment capacity will drive most investor or investment facilitator decisions.

5) Lack of Development Track Record or Belief the Team is Otherwise Not Ready

While this reason could fit under wrong team it is really a different challenge. This factor is really about an investor’s view of the potential for execution and operational risk associated with the development team’s ability to manage the “unknown unknowns” specific to the project. This can manifest itself in obvious ways, such as a new development team without project development or management experience.

Where this challenge seems to routinely surprise development teams is with a novel technology, or an application of an existing technology in a new geography or jurisdiction. Countless developers have asked (in one form or another) “how can lack of experience be counted against us, no one has ever done this?” The problem, from the investor’s perspective, is not that the team isn’t the best team to execute and run a project, but that without a record of success with the specific project, there is an unquantifiable risk that something will go wrong and prevent the investor from realizing its return. Sometimes this perception can be overcome by layering related experiences and demonstrating that the team is well-integrated and is aware that there are obstacles yet to emerge in the development, construction, and operation of the new project.

Conclusion

These challenges occur across every technology. While the sophistication associated with larger projects lessens the likelihood of one of these challenges emerging, I have seen these complications ruin very well-conceived multi-billion dollar projects, as completely as small projects seeking “merely” hundreds of thousands of dollars.

This list is, of course, not exhaustive (and please share experiences from either side of the development investment process). These are not hard and fast rules, exceptions do occur. Even with carefully planned energy projects, development teams need to find ways to not only define good project economics, but also to engage and manage the expectations of investors in order to find the necessary funding.

Similar but still different experiences- Several REALLY good projects offered to Clients never happened because of what SEEMED like good reasons to the players involved.

All of the corporate capital is being focused on X brand now, and the rest of us just have to get by.

We don’t have anyone to spare to run that project right now.

It’s probably worth while, but the CEO has just started in on his new pet project so we probably won’t get any funding- no sense in wasting our time asking.

Meanwhile, the company was likely losing maybe two or three million a year in something that would have had a 14-month payback.

Bottom line- If the folks “on-line” do not truly understand that wasting money puts their company, and their job, at risk- there is nothing that can be done to keep them from casually walking over the cliff hand-in-hand with their counterparts.

They don’t realize that a project that saves the company money will increase its profits, which will enhance that CEO’s bonus. IF they pitched it to him/her with that mindset- it would not only be funded, it would be fast-tracked with whatever resources were needed to get it done.

BUT- they would rather go on “doing their job” and not making waves and complaining about how they get no support for their efforts and have to keep chasing that CEO’s dreams.

The power industry is very good at making a cheap commodity in a very complex regulatory situations. Every state PUC will require ‘evidence’ that a ‘good’ project is actually ‘good’ for customers. The three most important things to consider is location, location, location. The average grid owner considers small independent power producers a nuisance that is easy to ignore. While they may be required by law to accept the power, they do not have to make it easy. On the other hand, if a utility representative asks ‘how will this help my customers’ then a major uncertainty has been addressed.

A second problem is safety. A utility that runs nuke or coal plants with very good safety records is not going to deal with folks that do not have the same high standards. For example, in the linked AOL article you can see the construction workers are wearing hard hats, safety shoes, protective eye wear, and gloves. That is good but often you see alternative energy projects where that is not the case.

Another very good article and responses thank you I have recently experienced some of these things from potential investors. The bureaucracy involved with uncertain results is definitely a barrier to entry.

I’m a layman when it comes to the details of investments into renewable energies, however I am fairly religous on reading everything I can on the subject of renewables. The main impedament that I have seen and which seems to be a taboo subject with the investment community is why they don’t really want to invest. This subject is the secondary investment that investors initiate along with the primary investment, and what is this? The flow of raw materials that are incorporated with producing energy,Oil, Gas, and Coal in which a secure and quick substantial return can be expected. These materials are easly manipulated in the commodity markets which we see everyday, it’s easy money.None of the major players want renewables because there is really no backdoor investment into raw materials that insures the anticipated flow of large sums of money. The Sun, Wind, Tidal, Geothermal,etc.etc. are all free for the use in renewable energy gerneration plants that are trying to get off the ground and get us to the next level of energy production.Old money is the problem today and until this can be confronted we as a civilization will not advance into the next stage of our potential

Since the “liar loans” crashed in 2008, lenders were forced to get fundamental about making loans; without cash flow, lenders should not lend.

(1) A lender’s focus is on the “reality check”. All we want is our loan payment on time, without drama. The acid test of a major project is this: are there any customers (pre-sales) or governmental sponsors who believe it will work as promised? If yes, lenders can make loans because the Project has cash flow to make the payments.

(2) Projects without committed customers need Venture Capital in order to get customers, and the VC’s take control of the project to make sure the customers are serviced. If you think about it, all a VC does is put a little money down and take ownership of the Board of Directors to assure the lender that customers will exist to make the payment.

Economic Darwinism: if a new project solves the problems of a major customer, financing is available. If a new idea is in search of customers, it needs Venture Capital for Proof of Concept, in order to attract a customer or sponsor.

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Elias Hinckley is a strategic advisor on energy finance and energy policy to investors, energy companies and governments. He is an energy and tax partner with the law firm Sullivan and Worcester where he helps his clients solve the challenges of a changing energy landscape by using his understanding of energy policy, regulation, and markets to quickly and creatively assemble successful energy deals.